Managing Financial Risks - Essay Example

Managing Financial Risks Submitted By May 7, 2007 Table of Contents Page Page Introduction 2 Types of Financial Risk 2 Capital Structure Management 4 Analysis of relevant project agreements 5 Identification of potential impacts of regulatory issues 7 Conclusion 10 Introduction As part of the assignment, this paper discusses ways to manage risks which also includes the types of financial risks, types of capital structure, financing arrangements of the project, analysis of relevant project agreements, identification of potential impacts of regulatory issues, and key risk management method. Types of Financial Risk Generally, in many industries, types of risk involve business risk and financial risk. Business risk is, said Keown et al (1997), associated with the variability in the company’s earning before interest while financial risk is associated with the company’s financing decision. Types of financial risk that are typically found in renewable energy sector may be different from other industry sector. “Financial risks facing a company typically are those that exist because of market volatility” (Zolkos 2003). However, the amount of risk of the project depends on our perspective (Ibid). Generally, lenders are focusing on the ability of the borrowers to meet their financial obligation and each lender makes decision to issue the financing based on different factors. For example, an equity investor may want to base his decision on an estimation of the risk-adjusted return of the project. For renewable energy, the risk can easily be managed especially for on-grid renewable energy but the off-grid has different business model. Seeing the nature of the project itself, financing tend to be the greatest risk because it requires huge capital outlay. According to SEFI, the project ability to service its debt is another risk associated with renewable energy. Besides business and financial risks, there are also technological risk, investment cost, current annual cost, and inflation. Technological risk is due to the cost. Financial institutions do not assume the risk of this kind of investment but government does through bilateral or multilateral schemes. Technological risk may also involve the nature of the primary source of energy such as in the case of wind energy and win farm. The risk involves the “direction, speed or hourly duration of wind blowing will not meet the necessary criteria may affect the operational costs” (Balkan Energy 2007). According to Balkan Energy (2007), as in its experience, business risk for renewable energy may include the possibility of the adverse effect of the market and the position of the company in the market. “The level of price parameters” or price preferential and the level of electricity to be generated by wind farm sites. The level of price parameters, said the Balkan Energy, are the “amount of investment costs, including the costs for grid connection to the respective transmission or distribution network; average annual output of wind farm sites. To increase the output, the optimum wind blowing parameters must be ensured depending on the location where the wind farm is to be constructed; level of operational costs; useful life of the assets necessary for generation of electricity (20 years on the average, optimum operation period of 15 years); and a rate of return.” Some risks are systematic and others represent market risk and both have effect on the variability of cash flows. Zolkon (2003), on the other hand, described, “Financial risks facing a company typically are those that exist because of market volatility, such as commodity price, interest rate and foreign exchange rate changes, and other risks that might be specific to the companys particular industry. Developing appropriate metrics and then risk/reward and value-based performance measures for managing financial risks involves a progression of steps. Assessing a companys capital adequacy involves a balance between its economic value — the companys balance sheet and economic capital — and its financial liquidity.” Capital Structure Management Risks can be diversified away and some cannot, said Keown et al (1997). In energy sector, the risks are fully diversified and though it looks like it has high risk, the risk in this project is actually small or cannot be properly assessed but too often, it is transferred to another account in the financial statement. It is small because it is diversified and it is well diversified to each individual. Capital structure may cause financial leverage effects such as the variability of earning per share that “accompanies the use of fixed-charge securities” (Ibid) and financial leverage that affect the “level of earning per share at a given EBIT under a specific capital structure” (Ibid). Another ways to manage capital structure are to by calculating the comparative leverage ratios and analyzing the corporate cash flows. For project development in developing or third world countries, government assumes the risk (SEFI) through bilateral/multilateral arrangement. The risk itself includes politics, regulatory, and country risks (Ibid). As a way to diversify financing agreement, firms may want to consider the following capital structure schemes: Existing Capital Structure With New Common Share Financing With New Debt Financing Long-term debt @t % Long-term debt @% Long-term debt at @% Common shares Common shares Long-term debt at @% Total liabilities and equity Total liabilities and equity Total liabilities and equity Common shares outstanding Common shares outstanding Common shares outstanding With projected EPS level - Existing capital structure can be calculated using the following formula: EBIT Less: interest expense EBIT Less taxes Net income Less preferred dividends Earnings available to common EPS Similarly, the same formula is applied for With New Common Share Financing and With New Debt Financing. The cost of debt/equity financing for a capital structure can be analyzed and assessed by calculating the company’s Net Present Value, which is the discounted after-tax cash flow and the Incremental Rate of Return (IRR). For projects whose returns are positive tend to have attractive Net Present Value and higher IRR. Keown et al (1997, 307) stated that capital structure management often give rise to cost because it “encompasses a natural conflict between shareholders and bondholders. Acting in the shareholders’ best interest might cause management to invest in extremely risky projects… A change in the risk structure of the firm’s assets would change the business risk exposure of the firm. This could lead to a downward revision of the bond rating the firm currently enjoys. A lowered bond rating in turn would lower the current market value of the firm’s bonds.” Analysis of relevant project agreements On page 21, SEFI stated, “fund investors, creditors, guarantors and governments are often more concerned about operational and financial risks being taken by the project sponsor relative to its financial and management capability and operational track record. Sponsors and governments may be concerned about the financial risk aversion of creditors and their ongoing commitment should the project run into difficulties during construction.” Similarly, they argue that implementing renewable energy technology in developing countries through secure loans helps developers and their equity sponsors to provide between 10% and 50% of the capital needed for the project in a form of shareholders equity. The risk may be larger because lenders who have stake as shareholders equity often require playing greater role in the company’s financing structure. In Canada, the minimum mandatory financial requirements for equity financing are: Total project equity as a % of total project financing Minimum tangible net worth (in $ per MW of RES II contract capacity) Up to and including 25% of total project financing $125,000/MW 25% and up to 50% of total project financing $250,000/MW 50% and up to 75% of total project financing $375,000/MW 75% and up to 100% of total project financing $500,000/MW According to SEFI, in terms of project development and financing, each party involves want to earn income in the process. For example, bankers want to collect fees, lenders want to receive long-term and fixed payment in return of their investment, and investors want to collect pay back in short-term. This condition makes the project to become more scrutinized administratively than in its actual implementation. For example, for the contract to be rendered, the contractor must go through administrative assessment and evaluation that include the business plan, including the fatal flaw analysis, financial model the includes projected revenues and expenses, projected sales, return on investment, market/offtakers, input costs, competitors, substitutes, cash flows, contribution margin, IRR, and Net Present Value for the project. It also requires sensitivity analysis of changes in key assumptions, fuel source and security of supply (wind resource assessments), environmental approval, technology requirement, power purchase agreement, prices, experience and reliability or credit worthiness of all party involves, schedule breakdown security payments, insurance provision, environmental regulation should be met, project sponsor financial interest in the project itself, and risks assumptions about the contractor’s ability to service its debts. Identification of potential impacts of regulatory issues For the Canadian market of this project, it is required that for the equity shareholders, the “equity provider (or group of equity providers) that account(s) for the 35% or more of the total project equity must also demonstrate ability to access funds, either by having an Investment Grade Credit Rating, a confirmation letter from a prescribed lender, or a satisfactory Debt to EBITDA ratio” (Sebastiano, Osler, Hoskin & Haukin, 2005). According to Keown et al (1997, 34), the sole proprietor has absolute control of the firm and is not restrained by government regulations” and they can assume special names or licensing. Similarly, general partnerships are also not bounded by “any significant government regulations” (Ibid) so do limited partnership. However, when it involves general partnership, government regulation requires any detail agreements or changes to the contract to be made public in detail. The control of such companies also involves two levels. First in involves formal control, which is the common shareholders with the majority voting rights, and the preferred shareholders or the functional control shareholders who have more control over daily operation of the companies. The greater the size of the corporation, the wider is the separation between the common and preferred shareholders, and the more it is required to comply with government regulations and legislations and or that the company must comply with statutory requirements. All of these represent cost to the company which is often capitalized as organizational cost. In every case, the sole proprietorship is the cheapest organization to organize, said Keown et al (1997) but the risk of renewable energy project is too great to be carried by a sole proprietorship. They continued that corporation, though is more suitable for this type of project especially for a high cost of project in developing countries, it is very expensive because myriads of government regulations associated with its establishment, the company must comply with numerous statutory provisions. This makes the cost of organization increases just as its requirement and the formality of the organization. Regardless of the expensive cost of running, a corporation, which is more suited for this type of project, corporations that undergoes this project, tends to have the benefit of limited liability according to government regulations. Different from sole proprietorship or limited partnership, corporation allows the company to change or transfer ownership intrinsically and extrinsically. It guarantees the continuity of business. It is more attractive to raise capital, have better tax treatment in terms of income taxes, capital investment decisions, capital structure, and dividend policies. Unfortunately, much of the project associated with this nature has agreements and contracts whose players as if have been predetermined – from the banks that issue the fund based on the contract proposal, the selection process, the types of financing, and who the contractors are. In Canada, in fact, it indicates as if patronage overweighs the ethics of procurement. When it comes to liquidated damages, the contract requires that no liquidated damages for delay unless commercial operation is not achieved (Sabationo et al 2005) by certain dates. However, in any contract, neither no contingency or risk associated with politics, economic, nor social of the recipients have ever been taken into consideration but purely the company’s financial risks. Potential impacts of regulatory issues In public sector, environmental issue represents the main category in every strategic planning and budgeting (Gordon 1983; Koteen 1997). In treatment of environmental attributes, Canadian “considered contract related products excludes emission allowances and emission reduction credits… available to the contract facility” (Sabatiano et al 2005). Still associated with Canadian project, it contains a clause that says “supplier shall obtain and transfer to the buyer all environmental attributes” (Ibid). In the third world countries, this type of clause has become one of the reasons of environmental degradation and damaged eco system as well as human rights abuse. In practice, sometimes debt financing has been undertaken prior to contract agreement and it may cause the project to be rushed decided without thorough research and consideration of the future impacts. Key risk management methods Zolkos (2003) suggested that risk should not be eliminated but can be avoid, mitigated, retained, or transferred. By avoiding and mitigating the risks, they can be controlled and can be transferred through yet another way of debt financing. Debt financing has also becoming a popular term and fashion in the global market as companies are finding ways to merge or acquire and grow big. Eventually, from debt financing companies, it emerges as debt financing a country especially the third world countries which are buried in foreign debts. David Dodge, Bank of Canada Chairman has recently addressed his concern over debt financing phenomenon among private companies. While this phenomenon seems acceptable to commercial markets, debt financing is nothing less than the leverage buy out which was once banned by government. The key method of managing the risk is diversifying the portfolio of both systematic risk and market risk. Yet again, it depends on the company’s management decision process – what and how much the company is willing to bear the risk as part of its normal business, and what risks it should bear should it “transfer to one or more market participants” (SEFI). Conclusion As conclusion, risk can be an opportunity but also danger. Each company faces different type of risk and the way to manage the risk is depending on what and how well the company is willing to bear with the risk. However, the greatest methods to manage the risk effectively is by not only diversifying the risks but also by avoidance, mitigating, or transferring and retained. And Kushel (2006) suggested that the best method to manage risk is by curtailing it. References Gordon, Larry G. 1983. Strategic Planning for Local Government. Washington, DC, ICMA Keown, Arthur J.; Scott, David F. Jr.; Martin, John D.; Petty, J. William & McPeak, Davic W. 1997. Basic Financial Management. Second Canadian Edition. Scarborough, ON, Prentice Hall Canada. Koteen, Jack. 1997. Strategic Management for Public and Nonprofit Organizations: Managing public concerns in an era of limits. Second edition. Wesport, CT, Praeger Kushel, Rick. Sep2006. A Risk-Reducing Solution. Mortgage Banking . Vol. 66 (12): 88-92. EBSCO Business Source Premier, Walden University. [Access April 31, 2007] UNEP. 2004. Financial Risk Management: Instruments for Renewable Energy Projects. Summary document. United Nations Environment Programme Division of Technology, Industry and Economics. http://www.uneptie.org/energy/publications/pdfs/RE_Risk_Manag.pdf [Accessed April 27, 2007]. SEFI. Scoping Study on Financial Risk Management Instruments for Renewable Energy Projects United Nations Environment Programme. Reference Document. Marsh and McLennan Companies. http://www.uneptie.org/energy/projects/frmi/doc/Reference%20doc-RE%20risk%20study.pdf [Accessed April 27, 2007]. Sebastiano, Rocco M.; Osler; Hoskin& Harcourt. May 6, 2005. Renewable II RFP: An Overview of Mandatory Requirements and the RES II Contract. Presented at the Technical Consultation Session. http://www.ontarioelectricityrfp.ca/docs/R2Tech1P3.pdf. [Accessed May 2, 2007]. Zolkos, Rodd. 2003, 7/28. Manage financial risks, dont try to eliminate them. Business Insurance, Vol. 37 (30), 11. EBSCO Business Search Premier, Walden University. [Accessed April 27, 2007]. Wind Energy Overview - Bulgaria. http://www.balkan-energy.com/weob.htm [Accessed May 1, 2007] Read More